Thursday, March 13, 2008

Risk Of Rising Fuel Cost To The Airline Companies

With the fuel cost continuing to rise, the airline companies (such as Continential, Delta, American, Northwest, United, US Air, Southwest, JetBlue, etc) are again facing the possibility of entering Bankruptcy protection. According to the Air Transport Association, the fuel cost went from 10.5% of total operating expenses in 2001 to 24.4% in 2006 (as of 3Q 2007, this had increased to 26.5%). During the same period, the Passenger Unit Revenue (calculated at cents per Available Seat Miles, or ASM) increased 15.6% from 8.7 cents in 2001 to 10.06 cents in 2006[i]. Most of the revenue increase over this period could be explained by increased load factor (a full plane equals 100%), which went from 70% from 2001 to 79.2% in 2006. (This explains why the planes are now pretty much full.)

Additionally, airline companies have improved passenger airline fuel efficiency 36%, on average, and improved combined passenger and cargo airline fuel efficiency 24% from 2000 to 1st half of 2007[ii].

Even with the improvements in passenger and cargo airline fuel efficiency and higher load factors, the airline industry’s operating expenses in 2006 was 95.4% of operating income, resulting in a very thin 4.6% operating profit. With increasing fuel costs, this slim operating profit will be wiped out.

While the airline companies have done a tremendous job of improving their load factor and passenger and cargo airline fuel efficiency, the projection of higher fuel costs, leaves the airline companies with few options for staying in business.

Can The Airline Companies Survive?
In order for the airline companies to survive, they have to increase revenue sufficiently to overcome the increased expenses or to reduce operating costs further. Since fuel cost is the largest component of operating expenses, the focus of the airline industry, naturally, is firmly on ways to improve fuel efficiency.

Some of the steps proposed by the airline industry are[iii]:

· optimize flight planning for minimum fuel-burn routes and altitudes
· work with FAA to change en-route fuel reserve requirements to reflect state-of-the-art navigation, communication, surveillance and wind forecast systems
· employ self-imposed ground delays to reduce airborne holding
· modernize their fleets with more fuel-efficient airplanes
· invest in winglets to reduce aircraft drag and thereby increase fuel conservation
· redesign hubs and schedules to alleviate congestion
· advocate expanded and improved airfield capacity
· use airport power rather than onboard auxiliary power units (APUs) when at the gates
· change paint schemes to minimize heat absorption (which requires additional cooling)
· alter the location in which fuel is purchased (i.e., to avoid higher-priced west coast)
· pool resources to purchase fuel in bulk through alliances with other carriers

What Else Can The Airline Industry Do?
With all their fixation on improving fuel efficiency and cutting cost, there is one area that the airline industry doesn’t like to talk about: raising airfares.

While prices of goods and services in the U.S. has increased 3.1 times, based on CPI increase from 1978 to 2006, the price of air travel has only increased by 1.5 times, for domestic flights:

Click to enlarge

*Congress enacted legislation deregulating domestic airline passenger service in October 1978.
1. The College Board – based on beginning of academic year
2. U.S. Bureau of Labor Statistics – includes hedonic “quality-change” adjustments
3. U.S. Census Bureau – median value
4. ATA via U.S. Bureau of Transportation Statistics – excludes taxes
5. U.S. Postal Service – Publication 100
6. National Automobile Dealers Association – average retail selling price
7. U.S. Department of Energy – Monthly Energy Report, Table 9.4
8. National Association of Theatre Owners

Risks of Increasing Airfare:

§ Potential passengers, particularly the casual travelers, may switch to alternative form of transportation, leading to lower load factor.

§ Other air carriers, particularly the low cost air carriers, may not match the increased fare, leading to travelers switching to a lower cost carrier.

Any Other Options? – Thinking Outside The Box

§ Airline companies can begin charging for checked luggage. Since it cost approximately 5 cents to fly one pound 1,000 miles, any extra weight will burn extra fuel.

§ Begin charging by total weight. Air taxis that serve the remote regions of Alaska charge a flat rate up to a specified weight limit per person, typically 250 pounds. Anything more than this will either get left behind or will incur additional cost[iv]. It makes no economic sense to charge the same fare to a large person who brings on an overstuffed carry-on bag and a 10-year old child. Industry experts will tell you that additional weight costs the airline industry millions of dollars.

§ Reduce power-up cost by using aircraft tow tractors to tow the plane to the end of the runway before powering up the Jet. This might be too radical but a risk manger sometimes has to think outside the box. The aircraft two tractors can easily tow a B747 while burning far less fuel than the B747 would, going from the terminal to the runway. Oftentimes, the time from terminal to runway can take more than 30 minutes due to traffic. All this while, the airplane is burning tremendous amount of fuel, just idling.

There are risks to bold thinking but for the airline industries to survive, bold thinking will be necessary. The staid ideas of cutting service to reduce costs are not working. Moreover, there are very few remaining service items to cut. Therefore, the industry needs to think of ways to generate more revenue, and fast.

Ed Kim

DISCLOSURE: The author holds no long or short positions in Airline Companies at this time.

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